Although emerging markets (EMs) have outperformed developed markets by a substantial margin over time, we have recently seen some underperformance in EMs. This can be ascribed to investor fears brought on by geopolitical events. However, it’s important to remember that similar geopolitical events have occurred in the past – and EMs have outperformed developed markets over the long term, regardless. We believe that there is a significant disconnect between the fundamentals of EM companies and the macro noise reflected in the media, and that EMs still offer long-term growth opportunities.

EMs outperform developed markets over time, despite volatility over the short term.
Although EMs are riskier and more volatile than developed markets, they have outperformed developed markets dramatically since 1970. We calculated that if you had invested $1 million into the MSCI Emerging Markets Index in 1970, it would now be worth $173 million. This is $151 million more than what you would’ve earned from the MSCI World Index!

Looking past fear and focusing on company fundamentals reveals that EMs remain attractive.

Many EM companies are reporting robust growth in revenue and earnings, on the back of improving consumer sentiment. But because of the poor macro outlook and geopolitical events, share prices are being driven down and quality companies have become undervalued. This dislocation presents investors with great opportunities for selective stock picking and to invest in quality companies that were previously too expensive, and in so doing, continue to reap the benefits of EM outperformance.

The reasons why EMs outperform over time represent long-term factors that carry a lot of weight.

1. They are long-term drivers of growth.

EMs are under-represented in equity markets compared to their contribution to global GDP.
As countries move up the development curve, their stock markets typically grow. This results in a rising ratio of market capitalisation to GDP. It is interesting that the IMF expects EMs’ share of global GDP to increase at a growing pace going forward.

There are structural drivers of growth in EMs.An abundance of resources and human capital
The number of people and resources available in EMs is generally much higher than in developed markets, allowing more room for growth.Younger and faster-growing populations
EMs typically have populations that are much younger and growing at a faster rate, which further supports future growth, whereas the majority of developed market populations are ageing. The challenge that this represents is not only the number of older persons but also the ratio of older to younger people. An older and shrinking workforce places more demands and pressure on economies, such as an increasing demand for healthcare infrastructure and a decline in economic capacity and growth.Rapid urbanisation
The established urban areas that represent developed markets tend to dominate global economic activity (even more than the high population levels would suggest), which is evident in their considerably higher disposable incomes and wealth. Average urban incomes are roughly three times those of their rural counterparts in emerging countries like China and India. These income gaps, and the fact that urbanisation in EMs is expanding, show that there is scope for urbanisation to be a driver of growth in these countries. There is a lot of capacity available for urbanising EM cities to attract skilled workers, productive businesses and economies of scale that enable workers to be more productive and reduce the costs of supplying basic services.

2. Their valuations are attractive.
EMs are still attractively valued. This enables investors to potentially achieve superior long-term returns if they can identify and exploit the right investment opportunities.

Figure 2: EMs are attractively priced compared to developed markets (price to NAV)

Source: FactSet, as at 30 September 2018

Looking at fundamentals, where are the opportunities and how do we filter, screen and access these to avoid value traps?
We believe active, bottom-up fundamental investing is critical to understand the individual nuances of businesses and how they are affected by the country dynamics within which they operate, rather than making a macroeconomic regional or sector call based on geographic news flow.

What are the questions we are asking and factors we are watching to identify a positive tipping point for EMs?

When could the dollar weaken?

What will happen to the US market when rising interest rates force US companies to refinance the cheap debt they have used to fund leveraged share buybacks?

What will end the US-China trade wars?

What will the repercussions be if the Republicans lose seats during the 6 November US elections?

Inflation consensus and the US central bank’s decisions about interest rates will affect the dollar.

Long-term investors who can withstand short-term volatility should reap considerable long-term benefits when investing in EMs.
The attractive valuations and company fundamentals of EM companies, coupled with an abundance of natural resources, large and growing populations, and rapid urbanisation, should continue to support the strong growth we’ve seen in EMs. This gives patient, long-term investors the opportunity to earn attractive risk-adjusted returns, while diversifying their portfolios.

Neal Smith

The information in this communication or document belongs to Denker Capital (Pty) Ltd (Denker Capital). This information should only be evaluated for its intended purpose and may not be reproduced, distributed or published without our written consent. While we have undertaken to provide information that is true and not misleading in any way, all information provided by Denker Capital is not guaranteed and is for illustrative purposes only. The information does not take the circumstances of a particular person or entity into account and is not advice in relation to an investment or transaction. Because there are risks involved in buying or selling financial products, please do not rely on any information without appropriate advice from an independent financial adviser. We will not be held responsible for any loss or damages suffered by any person or entity as a result of them relying on, or not acting on, any of the information provided. Please note that past performances are not necessarily an accurate determination of future performances.
SCI stands for Sanlam Collective Investments (RF) (Pty), a registered and approved Manager in Collective Investment Schemes in Securities.

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About the author

Neal Smith

Neal manages the SIM Global Emerging Markets Fund. He joined SIM Global, now Denker Capital, in April 2012. Neal started his investments career at Alliance Bernstein as an equity analyst from 2001 to 2007, moving from their Cape Town to London office in the process. In 2007 he joined GLG Partners in London as a portfolio manager. After two years he moved on to Carlson Capital.